The Effect of Value Estimation Errors on Portfolio Growth Rates

Abstract

This paper analyzes the impact of value estimation errors on portfolios' growth rates and relative growth rates (i.e. long-term returns and long-term relative returns) for several portfolio weighting methods. The portfolio weighting methods include capitalization weights, estimation error neutral weights, estimation error independent weights, Funda-mental weights, and Diversity weights. The paper provides theoretical support, in the context of estimation error, for the empirical findings that many non-capitalization weighted portfolios beat the market's capitalization weights. It also provides a theory for the size effect.

Keywords: portfolio growth rate, estimation error

JEL Classification: G11